Working Capital Management Flashcards
What is a firm’s working capital?
Working capital = current assets - current liabilities
What does a working capital ratio say about a company?
It notes (a) the firm’s ability to pay off short-term debts (within one year) and (b) the firm’s ability to properly invest its assets
Thus, working capital could be too low, signaling that the firm is not sufficiently able to pay off debts – but it could also be too high, signaling that the firm hoards too much of its current assets when that could be making more money invested elsewhere
What are the assets included in current assets (and thus in working capital)?
(i) cash
(ii) marketable securities
(iii) accounts receivable
(iv) inventory
As regards cash, what are transaction balances and compensating balances?
Transaction balance = the total balance of cash due to routine collections and expenditures
Compensating balance = a minimum balance required by a bank below which fees will be charged on the account; this balance compensates the bank for their services, since it provides extra funds
As regards cash, what are precautionary balances and speculative balances?
Precautionary balance = a balance maintained in case budgetary forecasts for cash are not met
Speculative balance = a balance held for unexpected deals that may show up in the future
What are marketable securities?
Securities that are very liquid – i.e. that can be converted to cash very quickly and without much cost
Examples: Treasury bills, banker’s acceptances, commercial paper
Why are marketable securities generally held?
They can serve as temporary investments (earning more than cash), or they can be held as a substitute for cash in emergencies
What is one practice a firm can implement to reduce its transaction and precautionary balances?
Better align inflows and outflows of cash – properly timed, this will keep balances very low
Also can speed up collections and slow down payments (within legal and ethical boundaries) as needed
As regards cash, what is float?
Discrepancies between accounts (usually a firm’s books and a bank account) arising due to the money being in transit
If there is delay on checks to others, then the account is higher than it would be, so it is a positive float
-likewise, if there is a delay on incoming checks, it is a negative float
Firms have different times when they need more cash and other times when they need less; what are different strategies for dealing with this?
(1) investing in marketable securities and converting them to cash as needed has the benefits of avoiding debt and retaining a precautionary balance, but has the drawback of not maximizing returns on assets
(2) engaging in short-term debt when more cash is needed has the benefit of increasing returns on assets (since they’re not tied up in marketable securities), but has the drawbacks of paying interest and lacking any precautionary balances
A combination of the two can of course be utilized
What are ordinary features of marketable securities?
Because they need to be converted into cash quickly, marketable securities are often (i) very liquid and (ii) safe (i.e. low risk)
What is the Baumol-Tobin model?
A model made by William Baumol and James Tobin designed to show the optimal cash balance a firm should hold, balancing both (a) the liquidity that comes with holding cash and (b) the return or interest forgone in holding cash
This depends on the market interest rate, the fixed cost to convert cash to securities (or vice versa), and other factors
What are different elements of a firm’s credit (A/R) policy?
(1) credit standards
(2) credit quality
(3) credit period
(4) early-payment discounts
(5) collection policy
How do credit standards relate to a firm’s accounts receivable?
Definite credit standards help to show justifiable reasons why a firm can withhold credit from a potential customer (or reduce it) without breaking the law
Standards also save costs by avoiding default, costs to investigate particular customers (i.e. if there were no widely applicable standards), and costs for slow payment
How does credit quality relate to a firm’s accounts receivable?
Various factors about a customer can help to determine the likelihood that he will default – these include the three C’s of credit:
(i) character: the ethical disposition of the customer to honor his debt
(ii) capacity: the customer’s ability to repay based on his income
(iii) capital: the customer’s ability to repay (or provide collateral) based on his assets, in case income is insufficient
How does the credit period relate to a firm’s accounts receivable?
There is a trade-off in lengthening the time by which customers must pay their debt: lengthening the credit period increases sales but also increases the costs of A/Rs
-increases costs by increasing bad debt, slowing down payments, raising fixed transaction costs, and increasing the cost of carrying new receivables
If a firm’s credit period is extended, how is the increased investment in receivables calculated?
(1) increased investment in earlier sales
+
(2) increased investment in new sales
(1) = change in avg. collection period x sales/day
(2) = variable cost/sales x new avg. collection period x incremental sales per day
How do early-payment discounts relate to a firm’s accounts receivable?
Discounts for early payment of course help to reduce the collection period, but reduce total profits
Example: “3/5, n/30” means that 3% of the receivable will be discounted if paid within 5 days, and otherwise the net amount is due in 30 days
How does a collection policy relate to a firm’s accounts receivable?
Collections on overdue accounts can sometimes hurt the company by straining relations (and thus hurting goodwill)
Collections also can be expensive in how much labor they require
How do firms evaluate a change in credit policy?
Through incremental analysis – analyzing the additional sales and costs (and thus profits) caused by a given course of action
What are the different areas affected by a change in credit policy?
(i) sales
(ii) production costs due to increased sales
(iii) bad debt expense
(iv) early-payment discounts
(v) cost of capital to finance A/Rs
(vi) labor costs for credit administration
(vii) collection expenses
(viii) interest income (not applicable to most A/Rs)
What can a firm use to more clearly demarcate different A/Rs and thus keep better track of credit?
An aging schedule – keeping track of the outstanding duration for each receivable, especially since long-overdue A/Rs have a higher chance of nonpayment
What are some attributes of successful inventory management?
(i) high turnover
(ii) minimal disposals of obsolete inventory
(iii) minimal gaps in work/assembly
(iv) minimal missed sales from inventory shortages
What is the economic order quantity (EOQ)?
The optimal quantity of purchase orders (for inventory) that keeps order costs and carrying costs for inventory as low as possible
What is the formula for the economic order quantity (EOQ)?
EOQ = sq. rt. √[(2 x order cost x annual demand) / (inv. carrying cost per unit)]
This gives the optimal quantity of inventory units that should be added to inventory (purchased) at one time
Besides optimizing purchase orders, what else can the EOQ formula be used to calculate?
The optimal quantity in producing inventory (rather than purchasing it)
This would require the “order cost” in the formula to change to “setup cost” for manufacturing
As regards inventory, what is the lead time?
The time lapse between the beginning of a process and its end – in this case between ordering inventory and receiving it
As regards inventory, what is the reorder point?
The quantity at which more inventory needs to be ordered, given the time lag (lead time) between order and receipt
This will be the sum of any safety stock (i.e. kept for emergencies), if any, and the inventory for products demanded during the lead time
As regards inventory, how does a firm calculate the inventory needed for products demanded during the lead time?
Avg. inv. needed per day to meet demand
x maximum lead time
= max inv. needed to meet demand
Alternatively, the avg. lead time could be used, or the minimum lead time – but the maximum would be the least risky
When is short-term debt usually needed or utilized?
To meet seasonal needs and/or to finance current assets
How do interest rates on short-term debt compare to rates on long-term debt?
Short-term interest rates are ordinarily lower
How does risk vary for short-term debt and long-term debt?
Short-term debt is ordinarily riskier for the debtor than long-term debt:
- interest rates are more volatile
- lenders are less likely to extend loans if the debtor has trouble paying
How is a firm’s liquidity to meet short-term debt usually measured?
With the quick ratio/acid test ratio
(Cash + marketable securities + A/R) / (current liabilities)
OR: (current assets - inventory) / (current liabilities)
What is the main management consideration for accounts payable?
Ensuring correct decisions for early-payment discounts
Is the credit received for accounts payable free?
Strictly speaking, no, since the other company has various costs from extending credit for its receivables (the time value of money, administration costs, etc.) which are then passed on to customers despite their extended credit
Practically speaking, yes, since the company offering the credit usually doesn’t offer anything better for cash payments
Given that credit for A/Ps is practically free, what is the main management decision to be made?
Whether the discount for early payment should be accepted, or whether the company could gain more by investing the money and paying the full payable at the very end of the credit period
What is a practice firms could do to gain more from the credit of their A/Ps?
Stretch the terms of the contract – e.g. send a discounted payment after the discount date, or send the whole payment after the credit period
This will sometimes go unopposed (particularly if the other firm is tight financially and doesn’t want to lose a customer), but it lowers goodwill and could disincline the other company from help it might otherwise provide in the future
How does a firm mathematically decide whether to take the early-payment discount or not?
(1) the amount of extra credit gained by forgoing the discount should be calculated by taking the change in the daily avg. for A/P and multiplying that by the number of days credit is extended
(2) the amount of discount should be calculated (a simple % calculation)
If the early discount were selected, then (1) would be the opportunity cost of that selection, so the firm would have to get a greater return on investment from the extra credit (i.e. greater than (2) / (1)) in order to justify forgoing the credit
What is an example of a firm deciding whether to take an early-payment discount?
A firm has A/P of $73,000 to a merchant with terms 1/10, n/30
(1) change in daily avg. for A/P –> $73,000 / 365 days x (30 days - 10 days) = $4,000
- thus $4,000 is the extra credit gained by forgoing the discount
(2) discount = 1% x $73,000 = $730
The extra credit of $4,000 would have to generate more than $730 in order to be worth forgoing the discount, and thus the extra credit would have to generate a return beyond 18.25% ($730 / $4,000) for the decision to be rational
What are notes payable?
Short-term loans (often 90 days) firms take out with banks
Made with a promissory note, which is the contract specifying the loan conditions
How do compensating balances relate to notes payable?
Sometimes banks require borrowers to have a specific amount of the lent money held as a compensating balance in a checking account – this requires that much more cash to be borrowed, thus increasing the effective rate of interest
How do compensating balances increase the effective rate of interest for notes payable?
Since a compensating balance requirement would mean that the firm must borrow more money from the bank, the firm has to pay interest on that amount too, even though it’s required to hold that money with the bank – thus the interest rate paid on the real loan (the amount not held in the checking account) is effectively higher
What is a line of credit?
When a bank (or other financial institution) establishes a maximum borrowing amount which the customer can borrow from at any time
Besides interest on the borrowed amount, this sometimes involves a “commitment fee” to be paid on the unused credit
What is commercial paper?
An unsecured promissory note with a maturity under 270 days
The 270-day limit is to avoid the need of registering the paper with the SEC, thus reducing costs (and for the same reason it is often made to “sophisticated investors,” like mutual funds)
Who normally issues commercial paper?
Corporations with a healthy financial condition and good credit rating – otherwise the risk can be too much (or force the interest rates to be too high)
What are derivatives?
Financial contracts whose value is derived from an underlying asset
Ordinarily used to manage risk
What are forward contracts?
A type of derivative where the two parties agree to transact some asset on some future date at a price fixed in the present
A common type of forward contract exchanges foreign currency
What are futures contracts?
Similar to forward contracts except that these always take place on regulated exchanges, rather than as private transactions
How do futures contracts reduce the counterparty risk as compared to forward contracts?
Forward contracts, being made between private individuals, have a much higher risk that one party will default (counterparty risk)
Futures contracts, taking place on regulated exchanges, have a clearinghouse essentially act as the counterparty and thus reduce that risk, e.g. by having margin requirements for investors
How does “marking to market” relate to the decreased counterparty risk of futures contracts?
While forward contracts generally have one transfer of money take place during the contract, futures contracts require the difference between the originally-agreed-upon price and the daily futures price to be settled every day – thus money is transferred every day as the value of the contract is “marked to market”
Think of this as the fact that futures contracts require unrealized gains or losses on the changing futures rates to be realized every day
What is an interest rate swap?
Derivatives where two firms decide to exchange interest payments on each other’s loans
They do not exchange the principal, but they calculate the interest based on a “notional” amount, which is a hypothetical principal for which they are paying interest to the other firm
How does an interest rate swap work?
It usually requires one firm who wants a variable rate of interest and another who wants a fixed rate, and they also have different credit ratings
Each gets the opposite type of interest rate from their bank and then exchanges different interest rates with each other in such a way that they both gain
What is an example of an interest rate swap?
Co. X (who has a better credit rating) wants a variable rate while Co. Y wants a fixed rate – both their desired loans have the same principal
- X’s bank offers X either a 7% fixed rate or a variable rate equal to LIBOR
- Y’s bank offers Y either a 10% fixed rate or a variable rate equal to LIBOR + 1%
X selects its offered fixed rate (7%), while Y selects its offered variable rate (LIBOR + 1%)
-X and Y agree to swap interest rates: X will pay Y interest equal to LIBOR on the notional principal, while Y will pay X 8% interest
X receives 8% from Y, and pays 7% to its bank and LIBOR to Y – so X pays a total of LIBOR - 1% interest
- Y receives LIBOR from X, and pays LIBOR + 1% to its bank and 8% to X – so Y pays a total of 9%
- Thus both X and Y pay their desired type of rate (variable/fixed), and both pay less than what their banks offered
What is LIBOR?
London Interbank Offered Rate – calculated by primary banks in London to estimate the interest rate they would be charged if they borrowed from other banks
Most common benchmark for measuring short-term interest rates
Why does an interest rate swap work?
Imagine if two banks (one desiring fixed interest, the other variable) switched the exact interest rates they got from their bank – in such a case, the bank with the superior credit rating would lose a certain amount of interest and the bank with the inferior credit rating would gain a certain amount of interest
The point of a swap is that, if the gain on the above exchange is greater than the loss, then this net gain can be distributed between both banks in a swap so that it is mutually beneficial
What is an example showing why interest rate swaps work?
Co. X (who has a better credit rating) wants a variable rate while Co. Y wants a fixed rate – both their desired loans have the same principal
- X’s bank offers X either a 7% fixed rate or a variable rate equal to LIBOR
- Y’s bank offers Y either a 10% fixed rate or a variable rate equal to LIBOR + 1%
If X were to take Y’s variable rate (LIBOR + 1%), it would assume a rate 1% higher than the variable rate it could get from X’s bank (LIBOR)
- If Y were to take X’s fixed rate (7%), it would assume a rate 3% lower than the fixed rate it could get from Y’s bank (10%)
- Thus if they simply exchanged the exact rates they accepted, X would pay 1% more in interest and Y would pay 3% less
This net gain of 2% can be distributed between X and Y based on the terms of the swap – both would have to gain from it for parties to be willing to do it
-If there were no net gain, then no interest rate swap could be mutually profitable
What is an option contract?
A derivative contract involving a contract to buy or sell some underlying asset at a point in the future
Call option = right to buy
Put option = right to sell
